Monday, February 23, 2015

The outlook for Europe has improved significantly in the past month or so, a fact that still seems to be flying under the mainstream media's radar. On balance, the outlook for the global economy continues to improve. Very good news.

Released last Friday, the Markit Eurozone Composite Purchasing Managers' Index jumped to 53.5, as shown in the chart above. This means the outlook for the Eurozone economy has brightened considerably of late, no doubt due in part to a relaxation of Russia/Ukraine tensions and the likelihood of an acceptable solution to the Greek debt crisis. Even if Greece were to exit the Eurozone, its economy is so small that it wouldn't make much difference. The important issue here is to preserve the integrity of the Euro, a goal which appears to be widely shared among ECU members; if Greece exits, it will pay a price (i.e., the higher inflation that would follow a devaluation of its currency) that will deter others from doing the same. The experience of Argentina tells us that a big currency devaluation only provides a temporary boost to growth—as some of the capital that fled in anticipation of the devaluation returns—but in the end, the inflation that accompanies big devaluations is destructive, especially for the lower and middle classes.

Meanwhile, we recently learned that the German economy expanded at a 2.8% annualized rate in the fourth quarter of last year, up from zero in the second quarter. This is quite encouraging. After a pause in the second half of last year, the Eurozone economy appears to have re-synchronized with the U.S. economy, as both continue to grow. That is an important and positive change on the margin.

As the first of the two charts above shows, since the end of last year Eurozone equities have outperformed U.S. equities by an impressive 10%, after lagging miserably for the preceding five years. But don't get too excited, because in dollar terms, Eurozone equities are still down almost 8% from last summer's post-recession high. The recent relative outperformance of Eurozone equities is overshadowed by a much weaker Euro from a U.S. investor's perspective. Nevertheless, that doesn't negate the fact that Eurozone investors do see an improved economic outlook.

Japanese equities are now at a new 15-year high. The recent improvement in the equity market closely tracks the weakening of the yen, as seen in the first of the two charts above. But unlike the situation in the Eurozone, Japanese equities are up 30% in dollar terms in the past two years (i.e., equity market gains have been much larger than the weakening of the yen). On balance, the market is telling us that things have really improved in Japan in recent years.

As the second of the two charts above shows, the yen is for the first time in 30 years approximately equal to its Purchasing Power Parity value vis a vis the dollar—according to my calculations. It's not that the BoJ has severely depressed or devalued the yen, it's that the yen is now more "normally" valued. The BoJ appears to have successfully switched from a deflationary monetary policy to a neutral monetary policy, and that, in turn, has been a positive for the economy.

Even China is doing better these days: the Shanghai Composite index is up over 60% since last summer, even though growth in the Chinese economy has "slowed" to 7% a year. If only we could all grow 7% a year....

Positive developments overseas add up to a new all-time high for the value of global equities, as shown in the chart above. In the past six years, the market cap of global equities (in dollar terms) has increased more than 160%, rising from its March 2009 low of $25.5 trillion to over $67.3 trillion today. That's a gain of almost $42 trillion! Excluding the $16.8 trillion increase in U.S. equity valuations over this same period, the value of stock markets overseas has increased by $25 trillion. We are talking real, serious money, and a genuine recovery. That's not to say things couldn't or shouldn't be a whole lot better, but the improvement is impressive nonetheless.

Not everyone is doing so well, unfortunately. The Brazilian economy stands out in this regard, with its stock market having lost about 60% of its value in dollar terms in the past four years. Many emerging market economies (e.g., Argentina, Brazil, Venezuela) are burdened by weak commodity prices, poorly-designed fiscal and monetary policies, and endemic corruption.

Benjamin: Your "anti-noose" opinion has been on the money and for a long time now. The worry of all this supposed loose money would be inflation. But not only has inflation not reared its ugly head, but many indicators of inflation have actually eased (TIPS spreads, gold price, and others). From my perspective, animal spirits remain in the toilet as evidenced by super-low velocity, frustratingly low corp capex, and a still-crappy overall employment situation (despite the direction of the unemployment rate). In short, it would be the rapid rise of velocity - a reflection of animal spirits - that would really stoke the fire of inflation. But that isn't anywhere on the horizon. I am still lamenting the fact that there is very little effort to significantly improve our fiscal situation - where are the calls for lower income taxes, lower payroll taxes, understandable regulations, etc?

I remain generally queasy because I just don't trust our monetary mandarins to play a high-level game. But other than a justified fear of inflation in general, especially from those of us who can never completely rid ourselves of the mental baggage of the 70s, I'm not seeing the near term case for fearing inflation. Our much bigger concern should be economic growth which is still lacking.

And in their citizens's beliefs in a free lunch, government income distribution and that another country (the USA) is responsible for their problems. They keep election these promisers of a better life with no work.

Mathew--there are a lot of reasons why the US economy today is much less inflation prone then in the 1970s, including much less rate regulation, lower marginal tax rates and a huge increase in international trade. And a deunionized labor force. The world is much more competitive than 40 years ago.

The Fed could just about blow the roof off and I think we would maybe see 4 percent inflation.

benjamin, you omit THE greatest inflation deterrent-TECHNOLOGY! not only driving the price of "stuff" lower but undoubtedly the single greatest reason why standards of livings are way better now than at any point in history.

Love the technology--in my longer spiel I mention the Internet has created hell-prices for retailers and middle-men, globally. Craigslist has made the used and grey markets a reality in every major city.

With the Internet, also more to your point, new technology or insights are instantly broadcast globally. And there are smart people doing R&D in not just the US anymore, but Europe and Asia too.

Toyota is selling a fuel-cell car as we speak. Battery cars are on the road now. It is amazing.

Technology has done wonders for productivity and living standards, but it is not an antidote to inflation.

Inflation is a monetary phenomenon. Want an example? Consider Argentina, where there is plenty of technology. It is suffering from inflation of 30%. Why? Because of bad monetary policy. The central bank is truly "printing money." Currency in circulation has been growing 20-30% per year, and the peso has lost about 25% of its value every year for the past four years.

Scott-you should consider the role of primary dealers when discussing the Fed and QE. The increase in bank reserves was a result of the Fed crediting the accounts as depository institutions of the primary dealers, not the ultimate bond sellers.

Ergo when the Fed does QE actually prints money. Or digitizes. And it worked!

Benjamin: I've discussed the mechanics of QE many times. Bank reserves are not money that can be spent on anything. Banks and primary dealers bought bonds from the public, then sold the bonds to the Fed in exchange for reserves. The money the banks and dealers used to buy the bonds came from deposit inflows.

At the end of the day, banks effectively took in trillions of deposit inflows from the public, then lent the money to the Fed in exchange for reserves.

The money the banks and dealers used to buy the bonds came from deposit inflows.--Scott Grannis

This is incorrect.

Commercial banks cannot buy or sell bonds from the central bank.

Only the 22 primary dealers can do this. Those are the Cantor Fitzgeralds, Jefferies, and Nomura Securities and so forth. Not commercial banks.

When the NY Fed buys bonds from the primary dealers, it credits the accounts of the primary dealers at a depositary institution, creating the reserve. This is from the NY Fed web page:

“So when the Fed sends and receives funds from the [primary] dealer's account at its clearing bank [depositary institution, or commercial bank], this action adds or drains reserves to the banking system.”

But the primary dealers are only intermediaries.

They do not have $4 trillion in inventory. They bought bonds in the open market--and paid the bond sellers with cash. They essentially got the cash from the Federal Reserve.

In fact when QE started the primary dealers could not buy and sell bonds quickly enough to the Fed, using their own limited capital. So in 2008 the Fed created the Primary Dealer Credit Facility to essentially give the primary dealers enough cash they could get the ball rolling.

http://www.federalreserve.gov/newsevents/reform_pdcf.htm

Repeat--commercial banks cannot buy and sell bonds from the Fed. only primary dealers can do that.

The sentiment that "QE was just a swap of reserves for Treasuries" is glib and incorrect. From the view of the US taxpayer, it is correct--sort of. The Fed pays IoER, not taxpayers, and the Fed can pay IoER by printing up more cash, as John Cochrane points out.

But macro economically speaking, under QE the Fed printed up, or digitized $4 trillion and injected it into the economy.

See this too:

http://www.cnbc.com/id/101268683

You can download charts of commercial bank deposits 2008-2014 and see steady growth---but no $4 trillion bulge.

The people who sold bonds to the primary dealers and received the $4 trillion in fresh cash probably did bank some of the money and banks may have sat on it. But they also invested in other assets or spent the money.